We investigate the optimal regulation of financial conglomerates which combine
a bank and a non-bank financial institution. The conglomerates risk-taking incentives
depend upon the level of market discipline it faces, which in turn is
determined by the conglomerates liability strucure. We examine optimal capital
requirements for standalone institutions, for integrated financial conglomerates,
and for financial conglomerates that are structured as holding companies.
For a given risk profile, integrated conglomerates have a lower probability of
failure than either their standalone or decentralised equivalent. However, when
risk profiles are endogenously selected conglomeration may extend the reach
of the deposit insurance safety net and hence provide incentives for increased
risk-taking. As a result, integrated conglomerates may optimally attract higher
capital requirements. In contrast, decentralised conglomerates are able to hold
assets in the socially most efficient place. Their optimal capital requirements
encourage this. Hence, the practice of regulatory arbitrage, or of transfering
assets from one balance sheet to another, is welfare-increasing. We discuss the
policy implications of our finding in the context not only of the present debate
on the regulation of financial conglomerates but also in the light of existing
US bank holding company regulation.